# CAPE Ratio

## What is CAPE Ratio?

The CAPE (Cyclically Adjusted Price-to-Earnings) Ratio is calculated by dividing a company’s stock price by the average of a company’s inflation-adjusted earnings over ten years. CAPE ratio is also known as Shiller P/E or PE 10 Ratio.

It is widely used to measure the valuation of the S&P 500 index. The Shiller PE of the Standard and Poor's 500 (S&P 500) currently stood at just over 30 (as of early August 2020). Investors use CAPE Ratio to determine whether the price of a stock is correct or not. They also use the ratio as a valuation metric to forecast future returns.

Formula to calculate CAPE Ratio

Summary
• CAPE Ratio is used by financial analysts to assess long-term financial performance while isolating the impact of economic cycles. It suggests whether a stock is overvalued or undervalued.
• CAPE ratio was invented by an American economist, Robert Shiller.
• Cape Ratio is similar to (P/E) ratio and is used to analyze the financial performance of a publicly held company.

## What is the relation between CAPE Ratio, Earning Per Share (EPS) and (P/E) ratio?

Cape Ratio is considered similar to the Price-to-Earnings (P/E) ratio. P/E ratio tells you whether the price accurately reflects its earnings potential or its value over time.

It is the company’s market value per share to its Earning per Share. Earnings Per Share is equal to a company’s profit divided by number of outstanding shares.

An exceptionally high CAPE ratio implies that a company’s stock price is considerably higher than the earnings would suggest. This indicates that the stock is overvalued. It is believed that the market will ultimately push down the company’s stock price to its true value, thus correcting it.

## How can the CAPE Ratio help us understand the financial situation of a country?

The CAPE ratio has played an important role in spotting potential bubbles and market crashes. The highest level of the ratio for the S&P 500 Index is over 30. The history of the US financial markets witnessed record-high levels three times. The first was in 1929 before the Wall Street crash that marked the start of the Great Depression.  The second was in the late 1990s before the Dotcom Crash, and the third was in 2007 before the 2007-2008 Financial Crisis. Furthermore, lower CAPE ratio indicates higher returns for investors over time.

• CAPE ratio plays an important role in the identification of unusual bubbles, forecasting their bursts, and market crashes.
• Any change in CAPE Ratio affects the average returns. For instance, when the CAPE is between 10-15, the returns average is around 8 percent per year. Moreover, when the CAPE ratio is between 15 and 20, the yields average 5 percent per year. As the CAPE ratio increases to 20 and 25, the average returns come down to 3 percent per annum. With the CAPE higher than 25, the average returns fall to around 1 percent per year.
• CAPE ratio plays a vital role in spotting potential bubbles and market crashes.
• CAPE Ratio can help in the predictability of near-term capital market returns.

• Critics of the CAPE ratio maintain that it is not that useful in analyzing the financial performance of a company as the method is backward looking rather than forward looking. Another contention is that the CAPE ratio relies on GAAP (generally accepted accounting principles) earnings and does not consider the changes in the accounting rules which have occurred over the recent years. GAAP provides a pessimistic view of future earnings.
• Some analysts also assert that instead of GAAP earnings, usage of consistent earnings data like the operating earnings or the or NIPA (national income and product account) after-tax corporate profits, improves the predicting ability of the CAPE model and predicts higher US equity returns.
• CAPE Ratio does not consider the dividend yield and ignores the risk-free rate investments in the market like the sovereign yield bonds.
• Moreover, it is believed that this method ignores the demand-supply function, which is one of the most important pillars of economics.
• Choice and investment patterns of people do not remain same always and changes over a period of time.